Many academic economists argue that if taxpayers are going to rescue the financial system, their money should be used to recapitalize the banks...

But recapitalizing the banking system would require much more than $700 billion, and involve the government in the ownership of hundreds of institutions. It would also be much less cost-effective than the Treasury strategy of jump-starting the market in mortgage-backed securities, which would bolster the finances of almost every bank, whether or not they wound up selling into the government-funded auctions for those securities.

Let me make two points, beyond what I have said previously, in favor of using net worth certificates instead of having the government join the mortgage securities trading poker table:

1. We've used net worth certificates before, and it worked. Better to go with tried and true than untried and speculative.

2. It is bad public policy to try to revive the secondary mortgage market. This market has always been a cesspool of rent-seeking and regulatory arbitrage. Forget using economic or financial analysis to explain the secondary mortgage market. Every major advance in mortgage securitization has consisted of lobbyists prying open a regulatory loophole and Wall Street coming up with new security products to drive a truck through it.

Regulators used the net-worth certificates and other accounting gimmicks to make it appear that savings and loans had more capital than they did. The regulators lowered minimum capital standards and encouraged institutions to grow their way out of problems. These policies played into the hands of the industry's plungers and speculators.

This refers to the experience in the early 1980's. Any capital forbearance, including net worth certificates, runs this risk. If you think that banks are passing up good loans because of capital requirements, then forbearance makes sense. If you think they are insolvent and would use forbearance to make desperate gambles, then the solution is to shut them down. I think that the FDIC should be making those calls.

Remember, we don't have a perfect solution here. The alternative of throwing $700 billion at the mortgage securities markets sets a really low bar in terms of reward-to-risk trade-offs. The only plan that I've seen that's worse is the one Yves Smith trashes.

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